ESG Derivatives – US Climate Finance Working Group

At the end of 2020, ISDA surveyed its membership to identify its priorities for the growth of derivatives-related environmental, social, and governance (“ESG”) issues. The membership answered that it expected growth in ESG derivatives and communicated a strong desire for documentation standardization.

On February 17 2021, the US Climate Finance Working Group, which comprises ISDA and 10 other trade associations, published a landmark set of principles: “Financing a US Transition to a Sustainable Low-carbon Economy”.

The intention behind these principles is to create a useful framework for considering environmental issues (the E in ESG), and offer perspectives from the broader financial services industry: investment banks, insurers, asset managers, investment funds, pension funds and other financial intermediaries.

The key principles include:

• setting science-based climate policy goals that would align with the Paris Agreement;
• increasing and strengthen US international engagement;
• providing clear long-term policy signals that foster innovation in financial services;
• pricing carbon and leverage the power of markets;
• minimizing costs and support jobs in the transition;
• fostering international harmonization of taxonomies, data standards and metrics;
• promoting more robust climate disclosure and international standards;
• ensuring climate-related financial regulation is risk-based;
• building capacity on climate risk modelling and scenario analysis; and
• strengthening post-disaster recovery, risk mitigation and adaptation.

The day after publication, ISDA’s Chief Executive Officer, Scott O’Malia, offered his informal comments in derivatiViews, noting that the transition to a green economy cannot be achieved without the financial industry.

Of the above principles, he highlighted the following as key: (1) development and harmonization of taxonomies, data standards and metrics which should provide the necessary clarity and verification to enable investors to access ESG related products; (2) establishing a price on carbon would also spur development of climate-related financial products and provide more transparent pricing of climate-related financial risks which would be critical to towards investing in new low-carbon technologies; (3) any climate-related financial regulation should be risk-based to avoid creating perverse incentives as this will ensure firms can manage their exposures appropriately and promote the development of new ESG linked products; (4) further work and international co-ordination on developing climate risk modelling and scenario analysis, so that parties are able to price climate-related risks and (5) strengthening post-disaster recovery, risk mitigation and adaptation, since appropriately structured ESG derivatives contracts will enable better hedging of climate-related risks.

In his informal remarks, Mr O’Malia emphasised that these principles would help firms set the foundations for further development of innovative ESG-related investment products and derivatives, and additionally, enable firms to efficiently invest in the ESG sector and/or hedge their risks associated with the trillions of dollars of green bonds and other instruments which may be issued to finance the transition to a green economy.

ESG related derivatives are sure to be a hot topic this year, follow the Long and Short of It to keep up-to-date with developments.